"XYZ Scheme is declaring 100 per cent dividend and my distributor is telling me to invest in this scheme."

"This is important information which I have received from my relationship manager that ABC Scheme is declaring a dividend of 50 per cent."

I come across statements like this every now and then where dividends declared by mutual funds are used as a bait to get investors to invest. The scenario is presented in a manner that if you invest Rs 100,000 today , you will receive a Rs 30,000 as dividend or some other amount based on the NAV of the fund. Nothing could be further from the truth.

Dividends are not any form of additional gains that you can expect. In fact, dividend in Mutual Funds is a function of Capital Appreciation. Let's say you invest on September 20, Rs 500,000  at an NAV of Rs 50. This means you end up getting 10000 units (have excluded Entry load for simplicity).

 Happy aren't you to receive Rs 100,000 as dividend. I wish it was this simple and easy to make money in just a few days . There would be far more billionaires and millionaires than we have now.

Now for the catch, after the dividend is declared the NAV of the fund falls down from Rs 50.00 to Rs40.00

Value of your holding = 10000*40= Rs. 400000. This along with the dividend already received of Rs 100,000 will translate into your original investment of Rs 500,000. So you see things are not as rosy as they are projected to be.

So how should one react to these advertisements that a 100 per cent dividend is being declared or should anyone invest just on the basis of this information. The answer is an outright no. However, People have utilized a strategy called Dividend Stripping on the basis of this information. This was more rampant when Mutual Funds used to declare dividends a month or so before the record date.

The way it works is as follows. Suppose you have a short term gain of around Rs. 100000 . Instead of paying a short term capital gains tax of Rs. 10000 (considering 10 per cent short term capital gains), you make an investment of Rs. 100000 in a fund to declare a dividend of say around 25 per cent (NAV= Rs. 25 ).

Number of Units you have : 4000
Dividend per unit = Rs. 2.50 (25 per cent)
Total Dividend Received : Rs. 10000
Value of your investment now : 4000 units * NAV (Rs 25-10 per cent) Rs 22.50 = Rs 90,000
Redeem your investment now for Rs 90,000 and you have a Rs 10,000 Short Term Capital Loss.

 Here you have received tax free dividend and you have been able to offset this against your short term capital gains.

Now your short term gain is around Rs 90,000 instead of the earlier Rs 100,000. This results in a saving of around Rs. 1000 or 10% for you.

IT Department through its annual budget have tried to fix this loophole by increasing the holding period of the investment post the record date based on whether it was bought 3 months before the record date or within 3 months of the record date.

SEBI on the other hand issued guidelines that required the AMC to issue a notice communicating the decision to distribute dividends within 1 calendar day of decision by the trustees. At the same time the record date should be 5 calendar days from the issue of this notice. Though these are steps in the right direction and dividend stripping has been slowed to a certain extent, AMCs in the race to gather more assets are still using this as a ploy.

Don't fall for this or any such trick as your purpose of investing in equity oriented funds should be capital appreciation and not because a dividend is being declared. Dividend Payout, Dividend Reinvestment and Growth are options to choose based on your situation and need.

Mutual Funds can only pay out dividends if they have made gains on the portfolio.  Dividends are like fruits on a tree...If you do not give enough time for the tree to grow...where will the fruits come from...Don't know about this but your dividend will certainly come out from your principal.

The author is a practising Certified Financial Planner. He can be reached at amar.pandit@moneycontrol.com

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